Energy Straight Talk

Evidence continues to mount that our approaches to gas prices are going to miss the target. To really address this issue, we must first understand what is causing it. For analysis, we'll often turn to the man who knows more about oil than any other living person: Dan Yergin, author of The Prize (highly recommended), who will be participating in hearings before lawmakers this week (article from the Times).

The Problem

We all know that gas prices are reaching record highs. Oil prices have doubled in the past year. Once we passed $100 per barrel, we exceeded the record high for oil in real terms. Such prices have obvious effects on our economy: travel is restricted, prices of food and other commodities, which depend upon transportation, increase. Our national security is at risk; availability and price of oil has been a deciding factor in countless battles, including many in World War II (The Prize is crucial reading for this). Much oil revenue goes to countries that are connected to terrorism.

The US is one of the top three oil producers in the world. Unfortunately, we consume nearly three times what we produce. As such, our oil production has little influence on world oil prices. While OPEC countries are not our largest suppliers of oil, due to their large influence over world supply, other producers like Canada and Mexico follow their lead in pricing. What does this all mean? It means that gas prices for Americans are largely subject to factors outside of American control.

The Causes

As discussion of this issue has increased, politicians, pundits, and experts have offered possible explanations for the high oil prices and, consequently, possible solutions.

The most obvious is American supply. Conservatives believe that by increasing our domestic supply of oil, we can address the problem. They propose drilling on the continental shelf, in shale oil, and ANWR. Will this solve our problem? Bush, Gingrich, HannityBeckEtc, and even our friends at Lybberty blog are putting their faith in drilling. However, this faith is misplaced. Increasing drilling takes a long time; ANWR is not expected to produce at steady-state capacity for at least 10 to 20 years (and that's assuming the oil companies, who already have more concessions than they can drill, will go there). Once we are at full production, these increases in drilling will be lucky to produce anywhere near 2 million barrels per day. With US consumption currently at 20 million (and likely to rise in 10 to 20 years), this is not sufficient for us to get useful influence over prices. Further, drilling advocates assume that all the new production will be consumed by Americans; but the companies that drill can sell their oil to anyone. In summary, drilling does not fix the real problems; it does not sufficiently affect prices or decrease our foreign oil dependency. This is a nonsolution. The most dangerous thing about this idea is that it tends to give Conservatives a false sense of security. Drilling might be ok if it were part of a comprehensive energy solution, but Conservatives' faith in drilling means that they won't look for a comprehensive solution.

Many Democrats believe that the problem is caused by speculators. If only we could more closely regulate oil markets, we could get control of the prices. This view ignores the cause of the speculation: buyers believe that the demand for oil will continue to rise relative to price in the future, so oil is a good investment. China recently demonstrated a great way to deal with this problem: scare investors by showing that oil demand will decrease in the future. Speculation is a consequence of high prices and high expectations; it will go away when a real solution is developed. Says Yergin, "Calling it speculation is way too simplistic." Democrats latch on to this nonsolution because it appeals to their populist instincts; it's always easy to demonize the capitalists!

In addition to a drilling obsession, Lybberty wants to place full responsibility for the crisis on the weak US dollar. Is this a factor? Absolutely. Is this the biggest factor; a deciding factor? Of course not. As mentioned before, when accounting for inflation oil prices are still far beyond previous highs. The dollar matters, especially when it comes to the "speculators", but a tightening of monetary policy, the usual prescription for a weak dollar, is not going to fix the oil crisis. Once again, another scapegoat that diverts attention from the real problem.

So, what is the real problem? Think back to your economics classes. World supplies are fairly inelastic; they don't respond quickly to changes in demand. Additionally, production slumps in Nigeria, Venezuela, and Mexico have constricted the supply. Most importantly, long-term rising demand in emerging markets like India and China have tightened the market. The long-term outlook for oil demand is that it will continue to increase faster than supply for many years, on a magnitude far greater than what the Republicans' drilling could offset. Because of this long-term outlook, oil producers naturally restrict supply because they know they can get better prices later. This is the problem, plain and simple: demand exceeds supply, and there is no indication that that will change in the future. This is the argument of Yergin and most other informed observers.

Solutions

A solution must be found. Our relatively meager American daily capacity will not be sufficient, so drilling is not the answer. The weak dollar, while important, is not the primary culprit, so monetary policy will not solve the problem. Speculation is a consequence, not an ultimate cause, so chasing speculators will just waste time. America cannot control supply, but as many other countries have learned, we can alter demand. If the market is told that future demand will decline, present supply will increase and present prices will fall. From the Times:

"Everyone would like to believe that there is a silver bullet - like a bubble or speculation - that can solve our oil problem," [Senator Chuck Schumer] said. Instead, he said, it would be better for the nation to focus on conserving energy and reducing its oil consumption.

In the long term, alternative energy will provide the security we need. But how do we get there? Many commentators, including economists, have been advocating a solution which would both address the oil demand problem and speed the development of alternative energy. This solution is the Pigovian tax.

Oil demand is elastic at around $4.00 per gallon. The government should set a price floor at $4.50. Additionally, a consumption tax should be added to the gas. This tax would be offset by decreases in income taxes. As Charles Krauthammer suggests, guarantee that the tax will increase every six months. Oil producers now know that demand is declining, not increasing, so current supplies will increase and prices must go down.

However, we don't abandon the price floor once prices go down. The decreasing oil demand has another effect: it creates powerful incentives for the private sector development of alternative energy (much like the current price crisis caused GM to expand its battery development program). This incentive is far larger and more comprehensive than McCain's feeble $300 million contest. As gas prices go down, the amount of money the government pockets on each gallon of gas goes up; this money could be returned to taxpayers or, more effectively, used to pay off our $9 trillion debt - increasing growth possibilities for the future. Perhaps Republicans will want to use it to invade Iran, or maybe the Democrats will use it to give free lollipops to everyone (because all Americans deserve free lollipops).

As Thomas Friedman has argued, eventually most consumers will be driving electric cars. Hopefully these will be powered by a mostly nuclear grid. The US certainly produces enough oil for the rest - commercial transport and tourism, military, etc. This would be the path to energy independence. Increasing amounts of observers are advocating this policy, including Friedman, Mankiw, and Krauthammer. So does this mean it is political infeasible? It doesn't have to.

The reason ideas like this don't gain traction is that politicians and pundits are busy focusing on nonsolutions. As long as conservative politicians and commentators continue to peddle the drilling nonsolution, and as long as Obama and the Dems cry about the speculators and evil oil companies, real solutions will not be found. The candidate who can show the American people what is causing our current crisis and offer a real solution can make the other guy look like a Luddite. The commentators who abandon the partisan energy dogma in favor of pragmatic analysis will contribute to the solution. The sooner we fix the problem the better we are in the long run.

The politics is the difficult part. But this campaign provides an opportunity, argues Irwin Steltzer, for John McCain:

Finally, and this would require a leap of political courage, McCain should spend ten minutes with his adviser Douglas Holtz-Eakin, who I would guess is still recovering from his embarrassment at McCain's call for a cut in gasoline taxes, to discuss the opposite: a tax on oil products, especially gasoline and heating oil. This doesn't mean abandoning his opposition to higher taxes. Indeed, the point is not to raise federal revenues. Every dollar that comes in should be rebated, perhaps by reducing the payroll taxes of everyone earning less than, say, $50,000 per year, the group Obama intends to benefit by raising taxes on those energetic small-business owners. The beneficiaries of the McCain shift in taxes from work to polluting, imported gasoline would see the reduction in taxes immediately--when they received their first salary check after the new regime was in place. But the main point is this: The money that the Saudis and other supporters of jihadists would otherwise get would be reducing the taxes of hard-pressed Middle America. Take that, Barack Obama. It's called straight talk.

I don't advocate this exact policy, but something similar can be done. Some straight talk on energy would be a welcome relief from the irrational barrage of politicians and pundits. Take that, Sean Hannity. It's called straight talk.

Essential reading on this subject:

- The Prize by Daniel Yergin - nearly 1000 pages of the fascinating history of oil.
- Articles by Thomas Friedman: "Coulda, Woulda, Shoulda", a plea for a pragmatic president, and "Truth or Consequences"
- By Charles Krauthammer: "At $4, Everybody Gets Rational"
- The Economist: "Still Sky High", a reminder that gas-tax holidays, drilling, and begging the Saudis just aren't solutions. Supply and Demand are at work.